Dow-Gold Ratio Likely To Reach 1 In An Inflationary Scenario

I am revisiting the topic of the Dow-Gold ratio and its probability of touching one over the next decade at a critical juncture when –

1)Gold is at record highs (nominal terms) and the long-term prospects of price appreciation for the precious metal still look bright.

2)There are emerging signs of weakness in the global economy and the Dow Jones has corrected by 15% from its recent peak of 12,719 in July 2011.

3)The Dow-Gold ratio is at its lowest levels since the 1987 stock market crash.

This article looks into the probability of the ratio touching one over the next decade. More importantly, will the ratio touch one in an inflationary or deflationary environment?

The Dow-Gold ratio touching one is a phenomenon, which has been observed several times in the past. Most recently, the Dow-Gold ratio touched one in 1980.

Since the lows of 1980, the ratio trended higher for the next two decades, touching levels of 44 during 1999. I must mention here that this corresponded with a 20-year bear market for commodities, which resulted in relatively low inflation. At the same time, the equity markets witnessed a bull phase.

However, the Dow-Gold ratio has been on a steady decline post 2000, with the ratio touching its lowest level (in the last decade) currently. The same is evident from the chart below giving us the 200-year Dow-Gold ratio.

click to enlarge

Click to enlarge Source - Sharelynx.com

What is important to note here is that the debt ceiling in the United States has been raised from USD6 trillion in 2000 to over USD16 trillion currently (USD10 trillion in the last decade). However, during the period between 1980-2000, the debt ceiling increased from around USD1 trillion to USD6 trillion (USD5 trillion over two decades).

I mention this here to point out the impact of huge budget deficits and high government debt on different asset classes (especially gold).

Further, even after significant quantitative easing and artificially low interest rates, the Dow Jones is still lower than its levels witnessed in early 2000. What this tells us is that the policymakers can (to some extent) control the amount of money in the economic system. However, they have no control over which asset class the money is invested.

Coming back to the current scenario, there is no doubt in my mind that the response to economic weakness would be another round of quantitative easing. The form in which the economic system is flooded with more money is debatable. However, the policy action of money printing is a certainty.

In other words, we will witness policy actions no different from those in the last ten years. In line with this rationale, we will experience movement in asset classes no different from that in the last ten years. Therefore, in my opinion –

1)Gold will continue to trend higher.

2)The U.S. stock markets will continue trading in a very broad range.

However, if inflation does become a major concern, then equity markets might trend higher (in nominal terms), while gold’s ascent is relatively faster.

Going by the policy actions, my opinion is that the Dow-Gold ratio has a higher probability of touching one in an inflationary scenario than a deflationary scenario.

I must add here that we might see significant inflation followed by deflation in the economic system a few years down the line. A prolonged deflation scenario is only likely when there is a collapse of the financial system. Even if this has to happen, this will not be before we experience some serious inflation.

Therefore, my conclusion would be that there is a high likelihood of the Dow-Gold ratio reaching one over the next decade in an inflationary scenario.

In line with this conclusion, I will personally look to –

1)Add gold to my portfolio on corrections

2)Consider investment in the Dow Jones index more as a trading play than a long-term buy and hold

I would add here that many individual stocks might outperform the index and even gold during this period. Therefore, I am not suggesting that equity investment would be a bad idea. All I am suggesting is that investing long-term in the index might not generate good real returns.

In conclusion, the Dow-Gold ratio at one might not be a pleasant scenario for everyone. However, it seems very likely with governments not willing to change their policy actions.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.